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The Dreaded “D” Word – The Scare of Deflation

For several years now, we have heard pundits and prognosticators go on and on about the risks of strong – even perhaps runaway – inflation as a result of too much easy monetary policy for too long. Five years into the great experiment of zero interest rate policy, we still show headline inflation numbers to be running below the Fed’s stated goal of 2%. It seems that the vigilance that has been paid to curbing a rapid path of inflation is now creating concern about just the opposite – a significant period of weakening or falling prices. We see this situation in Europe as prices are currently flat or falling. Japan is struggling to recover from over two decades of deflation. Even in China, which has been a leading economy for some time, price growth is just half of the official four percent target.

On the surface, falling prices would seem to be beneficial for consumers. As oil prices have tumbled from $115 per barrel in June to around $80 today, this is freeing billions of dollars for consumers to spend on other items. Yet with an annual rate of inflation through September running at 1.7%, the prices consumer paid were relatively flat or falling in many other areas, particularly imported goods.

So what is the problem then? It has to do with the other side of the equation – the producer side of things. When consumers come to expect that prices will remain flat – or even fall – they respond by putting off spending. The theory is why buy now if there is the strong possibility that the item will be even less expensive next month? When businesses try to raise prices, consumers respond by cutting spending. A perfect example of this lack of pricing power was recently illustrated in comments from Nestle, the world’s biggest food company. They informed investors that they have no pricing power in many key markets, a view shared by other companies in many different industries. The lack of demand for goods causes more discounting as companies struggle to survive. If sales don’t recover, then companies either cut wages or lay off workers, causing them to have less to spend further depressing spending – and the cycle goes on. One need look no further than Japan since the 1990’s to see just how powerful this cycle can be.

Deflation can also disrupt the world of lending. With an appropriate level of inflation, business revenues grow which leads to wage growth for employees. This makes payments on fixed-rate loans cheaper over time. The opposite is true with deflation, making debt costs higher which can lead to greater levels of defaults. As defaults rise, this further pushes down the prices of underlying assets – just think about our housing crisis – and ultimate crash – in 2008. This cycle of price and debt deflation can be challenging to break. The efforts of our Fed for the past five years have been partially in an effort to avoid a second Great Depression and this sort of deflationary cycle.

At this point of the cycle, the monetary “magic” is beginning to wear off. The Fed announced on Wednesday an end to its latest round of bond purchases. While we are seeing continual improvements in the labor market, the missing piece up to this point has been wage growth that would help to fend off the deflation “demons”.

How might this information impact your trading and investment decisions? I am closing watching inputs like the personal income and spending report, which outlines wages and salaries as well as disposable income, for clues going forward about the strength of our underlying economy. If the market begins to truly fear deflation, then we may continue to experience higher levels of volatility in markets as well as the possibility of a top beginning to form. While I don’t see this playing out in market price action the last several weeks as we sit at all-time highs, the increasing level of volatility may be indicating a new fear underlying the situation. It pays to know how to hedge the risk of a falling market while allowing profitability to continue in the bullish scenario. That is exactly what we teach our students to do at OptionsAnimal.